Revocable Living Trust and How It Works

A revocable living trust––sometimes simply called a living trust––is a legal entity created to hold ownership of an individual's assets. The person who forms the trust is called the grantor or trustmaker, and in most cases, also serves as the trustee, controlling and managing the assets placed there. Some trustmakers prefer to have an institution or attorney acts as trustee, although this is somewhat uncommon with this type of trust.

A revocable living trust covers three phases of the trustmaker's life: his lifetime, possible incapacitation, and what happens after his death.

Phase One of a Revocable Living Trust: The Trustmaker is Alive and Well

The trust's formation documents should include specific provisions allowing the trustmaker to invest and spend the trust assets for his benefit during his lifetime. The trustmaker can go about business as usual with the assets that have been transferred or funded into the trust's ownership, assuming no one else has been appointed to act as trustee. In this case, the trustee would typically take direction from the trustmaker.

The trustmaker reserves the right to undo a revocable trust -- thus the term "revocable." He can reclaim assets he's placed into it, divert the trust's income to himself or another beneficiary, sell the assets or place more assets into it. He maintains final control.

A revocable living trust does not have its taxpayer identification number, unlike an irrevocable trust -- one where the trustmaker gives up all control. A revocable trust and its trustmaker share the same Social Security number. Trust taxes are filed on the trustmaker's Form 1040, just as though he continued to hold ownership of the assets personally.

Phase Two of a Revocable Living Trust: The Trustmaker Becomes Mentally Incapacitated

The trust agreement should also specify what happens if the trustmaker becomes mentally incapacitated and can no longer manage his affairs and those of the trust. The trust documents should name a "successor trustee," someone to step in and take over management of the trust if the trustmaker is determined to be mentally incompetent. The successor trustee can then manage the trustmaker's finances and the assets that have been placed into the trust.

Phase Three of a Revocable Living Trust: The Trustmaker's Death

A revocable trust automatically becomes irrevocable when the trustmaker dies because he can no longer make changes to it. The named successor trustee steps in now as well, paying the trustmaker's final bills, debts and taxes, just as he would if the trustmaker became incapacitated. In the case of death, however, he would then distribute the remaining assets to the trust's beneficiaries according to instructions included in the trust's formation documents.

How a Revocable Living Trust Avoids Probate

The Internal Revenue Service and probate courts view revocable trusts a little differently. Because the trustmaker and the trust share the same Social Security number, assets placed in the trust do not avoid estate taxes. The trustmaker can reclaim them anytime he likes, so the IRS takes the position that he has not technically relinquished ownership as he would with an irrevocable trust, which does escape estate taxation.

The probate court says he has indeed relinquished ownership. He's given the assets to the trust, even though he could theoretically take them back. Assuming he hasn't done so as of his date of death, the trust's assets would not pass through probate. The successor trustee can settle the trust outside of court, without supervision.